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Reconciling equity and efficiency: a different take on taxation

By Gavin Putland - posted Saturday, 15 September 2001

A certain British MP, serving in Gladstone's "Great Parliament" of 1868-74, was a bleeding-hearted do-gooder obsessed with public education, workers' rights, tenants' rights, and even women's rights (in the 19th century!). You know the type; you've seen a few recent specimens on the Opposition/cross benches in Canberra. Also serving in the Great Parliament was a hard-headed economic rationalist who supported free enterprise and free trade and opposed government intervention and protective tariffs. Again you know the type; again you've seen a few recent clones in Canberra, mainly on the Government benches. Yet these were not two British MPs, but one: John Stuart Mill (1806-73). To reconcile Mill's apparently contradictory views, we must examine his then fashionable but now largely forgotten ideas on taxation.

The fundamental problem of taxation is the deadweight problem, which may be stated as follows:

  1. All revenue flowing into the public Treasury must be generated by some productive activity; but
  2. every tax discourages the activity that attracts the tax, along with any other activity that depends thereon.

For example, taxes on payrolls, personal income, superannuation, profit and consumption respectively discourage employment, work, saving, enterprise and retail shopping, and a slow-down in any of these activities causes further slow-downs elsewhere in the economy. Thus each of these taxes causes a contraction in its own revenue base and a consequent reduction in national income, which reduction is called the deadweight cost. A tax with a low deadweight cost is said to be efficient.

A partial solution to the deadweight problem is to tax expenditure on necessities of life, so that people cannot easily avoid "the activity that attracts the tax". Another partial solution is to impose a very low threshold on personal income tax and minimize marginal rates on high income earners, so that low income earners have to work harder for financial survival, while high income earners are not discouraged from earning still more.

These approaches, which reduce deadweight by imposing a disproportionate burden on the poor, illustrate the second great problem of taxation: the so-called equity/efficiency conflict.

The above exposition, although quite conventional, is misleading because the deadweight effect stated in points I and II has a gaping loophole. The activity that generates the revenue (in point I) may not be the same one that attracts the tax (in point II), in which case the latter may be taxed without discouraging the former. Moreover, the "activity" that attracts the tax may be nothing but a niche created by the economic system and not by any particular player within it, in which case the niche will continue to exist regardless of who (if anyone) occupies it or what taxes are imposed on it.

An example: You have probably heard that "house prices" in Australia are soaring, but they're not. The truth is that while established houses are depreciating because of wear and tear, and while new houses are getting cheaper in real terms because of improving construction technology, the value of the land under those houses is soaring. The increase in the value of land is called the unearned increment. Enter John Stuart Mill. Suppose every piece of land is subject to an annual tax equal to the current assessed rental value of the land (excluding buildings and other improvements) minus the assessed rental value of the land at the date of introduction of the tax (the reference date), adjusted for inflation. The real after-tax rental value remains constant, and the real sale price, which is the lump-sum equivalent of the real after-tax rental value, is constant for a given real interest rate. As a guarantee against overtaxation, the State makes a standing offer to buy back the land for its real market value at the reference date. These are the essential features of the Mill tax.

For a particular piece of land subject to a Mill tax, the activity that generates the revenue includes everything that increases the value of the land, such as population growth (which increases the need for land), economic growth (which increases the capacity to pay for land) and public works and technological progress (which improve services to land). None of this has anything to do with the "activity" that attracts the tax, which is simply owning the land. Moreover, land ownership is an indestructible economic niche, because the land is a free gift of nature and someone must legally "own" it; if all else fails, title will revert to the State, which will not be deterred by the need to pay tax to itself!


So a Mill tax has no deadweight cost. Furthermore, because landowners tend to be richer than non-landowners, and because unearned increments correlate strongly with financial comfort within the landowning class, a Mill tax is highly equitable; there is no equity/efficiency conflict.

In real life, however, only a token fraction of the unearned increment is taken as tax. In Australia, some is captured by municipal rates, while the rest is realized as increased rent and increased turnover, which are taxed like normal income, or as capital gains, which are taxed concessionally; indeed, capital gains on owner-occupied principal residences are not taxed at all. Hence you dream of owning your home -- or rather the land under it. Here are some of the consequences:

  1. The lure of the unearned increment creates a speculative demand for land, and this additional demand raises prices for first-time buyers.
  2. Land needed in the future is purchased early in an effort to "beat the speculators". This secondary speculative demand raises prices further.
  3. When you sell your home and buy another, the higher resale value of the first block of land is cancelled by the higher price of the second. You are chasing your tail. Thus the unearned increment is not simply a reward for owning land, but a reward for owning more land than you need – at the expense of those who own less.
  4. In the absence of a Mill tax, the forgone revenue must be raised by other means. Taxes on profits, payrolls or value added (GST) increase the prices that must be charged to maintain margins, while income taxes reduce consumers' capacity to pay. So all these taxes cause otherwise viable business locations to become unviable. As the taxes increase (e.g. from bracket creep), they turn once prosperous communities into urban blights and rural ghost-towns, close businesses, reduce competition, and consequently raise prices.
  5. Speculative demand for land is contractionary because it ties up savings and deters productive investment (as high interest rates do), and inflationary because it raises the cost of a necessity of life.
  6. These inflationary pressures increase the natural rate of unemployment, i.e. the rate consistent with non-accelerating inflation. And the bipartisan policy of keeping the inflation rate within a certain target range is effectively a policy of maintaining unemployment at the natural rate. You might lose your job. Your house and land might then be repossessed.

A Mill tax would give the unearned increment back to the community that created it. Implementation would rely on the same administrative machinery that currently assesses municipal rates in Queensland and NSW. High-income property owners would receive bills for the Mill tax, as they now do for rates. Lower-income home owners would probably be receiving some social security (e.g. family allowance) from which the Mill tax could be deducted like a PAYE tax. (It is even possible to combine a Mill tax with existing rates under a revenue-sharing formula, in which case the fully PAYE group would stop receiving rate bills.) In either case, compliance costs would be negligible. The Mill tax revenue would ramp up over time, and competition between political parties would ensure that other taxes ramped down. The above six points would then give way, respectively, to the following:

  1. Land becomes cheaper because speculative demand ceases -- not gradually, but immediately.
  2. There is no need to incur extra interest by buying land before it is needed.
  3. There is no cumulative reward or penalty for owning too much or too little land – no more free lunch for the rich at the expense of the poor.
  4. Ricardo's law states that if it is more profitable to do business on one site than on another, the additional demand for the first site will raise its rental value so as to cancel the difference. So the effect of rent is to equalize the profitability of all bare sites, reducing profit margins to those obtainable on marginal sites, i.e. sites with zero rental value. More desirable sites are called supermarginal (or viable) and yield positive rent. Less desirable sites are called submarginal (or unviable).
  5. Enter Mill. A Mill tax cannot cause supermarginal land to become submarginal, because marginal land pays no tax, while supermarginal land pays less than its full rental value in tax. Differences in Mill tax liabilities cannot be passed on in prices, because the higher-taxed businesses are in competition with lower-taxed ones. Furthermore, because a Mill tax is a fixed cost, it does not change the prices at which traders can maximize their profits (allowing for the effect of prices on sales); if traders could raise profits by raising prices, they would do so with or without a Mill tax. Consequently a Mill tax is not inflationary. (These arguments also apply to landlords, for whom rents correspond to prices and occupancy rates correspond to sales. So a Mill tax cannot be passed on in rents.)

  6. Contraction and inflation are no longer driven by land speculation.
  7. The end of inflationary speculation and the winding down of inflationary taxes give a low and falling natural rate (hence actual rate) of unemployment.

Australia's tax system diverts about a third of national income. Its incentives and disincentives extend into every aspect of life, influencing every economic decision from buying a chocolate bar to floating a billion-dollar company, so that its total effect on the economy is far greater than is suggested by its share of national income. Therefore, if we are foolhardy enough to tax the desirable voluntary activities of individuals and firms, we should expect the ill effects to be numerous and serious. The solution, as illustrated by the Mill tax, is to tap the natural revenues generated by the economic system as distinct from the individual players within it.

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About the Author

Gavin R. Putland is the director of the Land Values Research Group at Prosper Australia.

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